Sustainability of pension systems

Description: The project is comprised of three self-contained essays concerned with the economic implications of demographic change.

Essay 1, “Changing Demographics and Optimal Public Debt", investigates the link between anticipated demographic changes and growth maximizing public debt. The analysis is based on an OLG model with age related social spending (through benefits), cost of child rearing, retirement and stochastic death. We find that optimal public debt depends on age related spending provided a positive benefits rate. Through numerical analysis we conclude that the effect of future demographic changes on the optimal debt level are relatively benign in the typical OECD economy. This essay invites a host of extensions, such as analysis of transition paths between steady states, introduction of a public pension system, a small open economy version and simulation of specific economies.

Essay 2, “Reform and Backlash to Reform: Macroeconomic Effects of Longevity Adjustment to the Retirement Age and Public Pension Benefits”, analyses pension reforms aimed at mitigating the effects of demographic changes. By applying an OLG model it examines the consumption-savings decisions of agents faced with a rise in the retirement age. This continuous time model is based on the Blanchard-Yaari framework and features a public pension system. We find that as the labour output is raised at the extensive margin (i.e. raised retirement age) the labour output on the intensive margin decreases (i.e. young agents allocate more time to leisure). This implies a substitution effect between current leisure choice of the young cohort and anticipated retirement age. This essay could be extended to introduce government spending aimed at alleviating the burden of intergenerational transfers through deficits.

Essay 3, (TBD), the third essay has not been determined but it will maintain the theme of exploring the implications of demographic change.

From here to there: transition paths from high debt to sustainable fiscal strategies under adverse demographics

Title:From here to there: transition paths from high debt to sustainable fiscal strategies under adverse demographics

Description:Home ownership has important economic and social implications in a society. In order to pay back their mortgage redemption, actual and prospective home owners save more and tend to accumulate more wealth than renters. Typically home ownership increases over the life cycle. It becomes an important wealth component in retirement and provides an (implicit) annuity and insurance device against longevity risk. Therefore, especially ageing societies should benefit from efficient housing markets and high rates of home ownership. Quite surprisingly, despite huge tax incentives in most industrialized countries, ownership shares differ quite substantially across countries. So does the possession of financial wealth of older people in different countries. The projected population dynamics are also quite different. Moreover, countries differ in terms of their tax, pension and housing policy settings.

The proposed project aims to examine the asset accumulation and allocation in Denmark and Germany. To what extent can the differences in home ownership and financial assets be explained by differences in the population structure and dynamics? How important are institutional features such as the pension system, tax incentives or the market for mortgage loans? How does the ageing of the population affect the housing market in both countries the future? What are distributional and efficiency consequences of various tax and pension reforms in both countries? In order to answer these questions we will construct a computable general equilibrium (CGE) model with overlapping generations and uninsurable labour income which accounts for housing demand and home ownership.

The two research teams at the University of Würzburg and CBS will closely cooperate during the development of the model structure. Both models will apply the same preferences and technologies. However, they will differ in their population dynamics, their fiscal systems and their housing markets. Compared to similar previous quantitative studies, our approach offers three major innovations. First, we will not only consider steady state effects of policy changes but simulate the whole transition path in an ageing society. When we simulate the model with and without population dynamics we can identify the impact on ageing on the housing market. Second, when we implement policy reforms we will analyse intergenerational welfare changes. Finally, we plan to quantify the efficiency effects of policy reforms by means of lump‐sum compensation payments.

Both partners have previous working experience with quantitative life‐cycle models as well as pension and ageing issues in their respective countries. In our published simulation studies we typically analyse the transition path, intergenerational welfare effects and isolate aggregate efficiency consequences of specific policy reforms. However, our previous models never distinguished housing consumption and mortgage markets. Therefore the current project is a natural extension of our previous work. We want to integrate a PhD project with this research programme. We are convinced that the results from our project could be useful for the policy discussion both in Denmark and Germany. For example, in both countries the fear of future “old age poverty” is an important policy issue. Optimal policies that target the poor pensioners (for example by means‐testing) are therefore important in Denmark and Germany. Since both countries differ substantially in their current tax and transfer schemes we can hope that our study sheds some light on the advantages and disadvantages of the two systems.

Description: The task of achieving long-term fiscal sustainability is to a considerable extent complicated by the fiscal strain posed by ageing populations and uncovered expected financial liabilities associated with future public sector outlays to pensions, health care etc. Evidently, this calls for an active reform agenda, such as postponing the retirement age and restructuring the pension system to rely more heavily on (individual as well as collective) retirement savings by households.

This paper focuses on the Danish pension system, which has attracted a lot of international attention in recent years. The system is highly ranked in global comparisons, and it has been seen as a role model for how to achieve good coverage, provision of adequate benefits and not least for its contributions to keep fiscal policy on a sustainable path. Yet, this paper argues that the system is subject to two important challenges:

First, due to means-testing of pension benefits, the effective return on occupational pension (OP) savings is very low, especially for low-income groups close to retirement age. There is a serious concern that unless this problem is appropriately addressed in the not so distant future, the payments to the OP system may be dramatically reduced. Against this background, the paper’s first contribution is to show how key fiscal and macroeconomic performance indicators would respond if payments to the OP system are phased out because of weak incentives to contribute to the OP schemes.

Second, due to anticipated violations of the rules stipulated by the fiscal framework in the EU, Denmark might feel tempted to change the tax treatment of funded pensions. Like in most other member states, in Denmark OP contributions are tax deductible, whereas OP benefits are taxed. The paper argues that a change of this set-up, such that contributions are taxed while benefits are untaxed, could seriously endanger the sustainability of public finances. Given the poor performance of public finances throughout Europe, and the need for fiscal adjustments in order to comply with national as well as supranational criteria, this is a theme of wider interest.

This project outlines the OP system in Denmark; explains the analytical framework used throughout the study: the DREAM model; addresses the effects of a gradual phase-out of the OP schemes; studies the implications of abolishing the existing system of deferred taxation of OP savings; points out some lessons for other countries.

Description: Our analysis is based on an economy with successive generations of workers who produce, consume, save and have children when they are young; but consume, spend their pensions when retired. Adjustments are made for time spent out of the labour force (for child rearing) and for survival rate into retirement. Social support and the consequences of ageing are funded by a social security tax on income, paid out at uniform average benefit rate. This framework has already led to a couple papers (Bokan et al. 2016; Hughes Hallett et al., 2016). For example, we have shown how a country’s fiscal position and efficient (growth maximizing) debt burden increase or decrease with demographic change, such as increasing longevity or migration.

Our agenda for what we plan to do next includes a range of topics, roughly in order of priority:

1) Examine the quality and potential risks in the macroeconomic and fiscal transition paths from the current position to the steady states we have identified. What does the best path look like? This involves (i) a technical summary of what dynamics are possible/optimal; and (b) a political economy analysis of (the risks in) making these dynamic adjustments.

2) The consequences of building in a public pension system.

3) Compare different countries with different demographic or fiscal characteristics. What factors make the adjustment paths easier, or more difficult or riskier?

4) What difference does it make if the economy is open to trade and investment? Compare small open economies to a large, more closed economy.

5) Examine in more detail the role played by (or concern for) income inequality in the transition.